In the opening paragraphs, Walsh contends that general obligation bonds (GO) issued by state and local governments and with the pledge of their “full faith and credit” may not be as creditworthy as always assumed. About half of the $3.7 trillion municipal bond market is general obligation bonds. She dramatically states that investors who own GO bonds might be in for a “surprise:”

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

What goes unmentioned is that the halted debt repayment is happening in the context of an insolvent county in bankruptcy. More importantly, general obligations bonds can be very high-quality from a strong issuer with top credit ratings, or they could be very low-quality from a near-insolvent municipality with the lowest possible credit ratings. The type of the bond is no assurance of ability to repay bondholders.

The point of a municipality seeking bankruptcy court protection is to halt the legal actions of creditors, including GO bondholders. This gives debtors time and a safe space to reorganize their finances. It’s not in any way “breaking with convention” to halt paying GO bondholders in bankruptcy.

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.

There is substantial case law, some of which dates to the 1980s, about GO bondholders being repaid less than their full claims in municipal bankruptcy (see footnote below). Investors are aware that municipal debt may have risk if the issuer is weak. That is why we have credit ratings to signal the risk of specific bonds.

After waving this false flag, Walsh finally gets around to explaining in the 19th paragraph that most of the debt of Jefferson County is not general obligation bonds anyway. In fact only 5 percent of the approximately $4 billion of Jefferson County debt is GO debt; the other 95 percent is revenue debt, which has claim only to the revenues of the entity the debt was issued for (say, a hospital, school or sewer project).

2010 ended with Meredith Whitney making claims about the enormous default likelihood in the municipal market. Municipal market professionals spent all of 2011 refuting Whitney’s unfounded claims. I really hope we don’t have to spend 2012 refuting more of the same nonsense.

Similarly, in the context of unsecured debt obligations (such as general obligation bonds), significant impairment is possible. See, e.g., In re City of Columbus Falls, Montana, Special Improvement District No. 25, 26, 28, 143 B.R. 750 (D. Mont. 1992) (approving plan that provided for less than full payment of general obligation bonds, holding that municipal debtor is empowered to impair prepetition general obligation bonds as long as other requirements of chapter 9 were met); In re Sanitary & Improvement Dist. #7, 98 B.R. 970 (Bankr. D. Neb. 1989) (explaining that general obligation bonds are general unsecured claims, subject to impairment); In re City of Camp Wood, Texas, Case No. 05-54480 (Bankr. W. D. Tex. June 13, 2007) (approving plan of adjustment that impaired prepetition general obligation bond debt through (a) a principal reduction, funded through a sale of assets; (b) a new 20-year amortization schedule; and (c) a new interest rate of 5 percent). Moreover, impairment is a possibility, even if the municipality has the ability to pay the obligation in full, through additional taxation or other measures. See Sanitary & Improvement Dist. #7, 98 B.R. at 974 (explaining that “[i]f a municipality were required to pay prepetition bondholders the full amount of their claim with interest … and the [debtor] had no ability to impair the bondholder claims over objection, the whole purpose of Chapter 9 would be of little value.”).

Walsh may have misstated a few things, but she has made an important point. GO apparently doesn’t mean what most investors think it does. The idea behind GO bonds is that they are supposed to be supported by the taxing power, which is theoretically unlimited. Of course bankruptcy courts should be able to discharge GO debt at some point, but shouldn’t that be only after the taxing power has at least been tried? What is shocking to me and possibly to many other GO investors is that the bankruptcy court can screw over the GO bondholders without even trying to order the municipality to honor its obligation to employ its taxing power to avoid default. Ok, the bankruptcy law is what it is, but it seems like bad law has been made here. This situation will raise funding costs for municipalities if the meaning of “full faith and credit” actually turns out to be that “we will only raise taxes if we feel like it,” which politicians rarely do. That is the point of the article, and I think it is a good one.

The term general obligation has one meaning in corporate finance but two in public finance. The presumption that a general obligation is an unsecured obligation in bankruptcy is not the case for municipal bonds. About half of all GO bonds outstanding are “secured” GO’s, a seeming contradiction of terms.

A municipal bond is a secured general obligation when voters approve issuance of the bonds and agree to tax themselves at an unlimited rate on real property to pay to pay back the loan. That grant does not apply to other expenses and financial obligations of the issuing locality.

It conveys to bondholders a first and exclusive lien on revenue derived from the taxation of real property. Hence the term secured general obligation more commonly known as voter approved unlimited tax GO’s.

Several state constitutions bar use of these monies for any purpose other than repayment of bonds secured in this manner. These bondholders have a higher position than creditors of corporations can attain. The bonds are essentially immune to adjustment under chapter nine of the federal bankruptcy law.

Federal courts have not shown much of an appetite to overturn contracts entered into by public vote pursuant to state constitutional law.

A major problem here is that the securities at issue are not Bonds, they are Warrants which were never approved by the voters. There appears to be an important question under Alabama law whether a municipality (like Jefferson County) can unilaterally act to raise taxes in order to satisfy these Warrants (assuming Jefferson County even wanted to voluntarily do so)without State approval.

We are currently investigating possible legal claims against certain parties involved with the underwriting of these Warrants.

TURNER LAW OFFICES, LLC
hturner@tloffices.com

Notice: The purpose of this posting is to identify select issues that may be of interest to readers. Under Georgia’s Code of Professional Responsibility, portions of this communication may constitute attorney advertising. This posting should not be construed as legal advice or opinion, and is not a substitute for the advice

One of the major challanges in the Jeffco Chapter 9 is that the securities at issue are not Bonds, they are Warrants. There appears to be an important question under Alabama law whether a municipality (like Jefferson County) can unilaterally act to raise taxes in order to satisfy these Warrants (assuming Jefferson County even wanted to voluntarily do so)without State approval.

We are currently investigating possible legal claims against certain parties involved with the underwriting of these Warrants.

TURNER LAW OFFICES, LLC
hturner@tloffices.com

Notice: The purpose of this posting is to identify select issues that may be of interest to readers. Under Georgia’s Code of Professional Responsibility, portions of this communication may constitute attorney advertising. This posting should not be construed as legal advice or opinion, and is not a substitute for the advice

Author Profile

I’m Cate Long and I write about the retail fixed income markets including municipal bonds. My primary interest is creating tools and systems to help retail investors understand bond markets. I’ve worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. I'm a guest contributor to Reuters.com. Any opinions expressed are mine alone.